Faculty of Business

International
Finance
IBF301 – FPT UNIVERSIT Y
CHAPTER 6
International Parity Relationships
and Forecasting Foreign Exchange
Rates
Introduction
This chapter examines several key international parity relationships, such as interest
rate parity and purchasing power parity
An understanding of these parity relationships provides insights into (i) how foreign
exchange rates are determined, and (ii) how to forecast foreign exchange rates.
Chapter Outline
1. Interest Rate Parity
2. Purchasing Power Parity
3. Fisher Effects
4. Forecasting Exchange Rates
1. Interest Rate Parity
IBF301 – CHAPTER 6
1. Interest Rate Parity
Interest Rate Parity (IRP) is an arbitrage condition that must hold when international financial
markets are in equilibrium. .

If IRP did not hold, then it would be possible for an astute trader to make unlimited amounts
of money exploiting the arbitrage opportunity.

Since we don’t typically observe persistent arbitrage conditions, we can safely assume that
IRP holds.
Example: Consider alternative one year investments for $100,000:

1. Invest in the U.S. at i$. Future value = $100,000 × (1 + i$)

2. Trade your $ for £ at the spot rate, invest $100,000/S$/£ in Britain at i£ while eliminating any
exchange rate risk by selling the future value of the British investment forward.
 Alternative 2:
Send your $ on a
$1,000 IRP
S$/£
round trip to
Step 2:
Britain
Invest those
pounds at i£
$1,000 Future Value =
$1,000  (1+ i£)
S$/£
Step 3: repatriate
Alternative 1: future value to the
invest $1,000 at i$ U.S.A.
= $1,000  (1+ i£) × F$/£
$1,000×(1 + i$)
S$/£
IRP

Since both of these investments have the same risk, they must have the same
future value—otherwise an arbitrage would exist
Interest Rate Parity Defined
The scale of the project is unimportant

$1,000  (1+ i ) × F
$1,000×(1 + i$) = £ $/£
S$/£
F$/£  (1+ i )
(1 + i$) = £
S$/£
(1 + i$)
F$/£ = S$/£ × (6.1)
(1+ i£)
Interest Rate Parity Defined
Dollar Cash flow from an
arbitrage

1 + i$ F$/ £ 1 + 𝑖$ (6.3)
Formally,
1 + i£ = S$/ £
OR 𝐹 = 𝑆[
1 + 𝑖£
]

F–S
IRP is sometimes approximated as i$ – i £ ≈ (6.4)
S
Covered Interest Arbitrage
When IRP doesn’t hold, the situation also gives rise to covered interest arbitrage
opportunities.

Consider the following set of foreign and domestic interest rates and spot and forward
exchange rates.

Example 6.1 (p154)

Spot exchange rate S($/£) = $1.8/£

360-day forward rate F360($/£) = $1.78/£
(6.5)
U.S. discount rate i$ = 5%
British discount rate i£ = 8%
Covered Interest Arbitrage
EXHIBIT 6.1 - Covered Interest Arbitrage: Cash Flow Analysis
Covered Interest Arbitrage
EXHIBIT 6.2 - The Interest Rate Parity Diagram Because every trader will
(i) borrow in the United States as much as possible,
(ii) lend in the U.K.,
(iii) buy the pound spot, and, at the same time,
(iv) sell the pound forward, the following
Adjustments will occur to the initial market condition
described in Equation 6.5:
1. The interest rate will rise in the United States (i$↑).
2. The interest rate will fall in the U.K. (i£↓).
3. The pound will appreciate in the spot market (S↑).
4. The pound will depreciate in the forward market
(F↓).
Covered Interest Arbitrage –
Example
Example 6.2 (p155):

Suppose that the market condition is summarized as follows:

❑ Three-month interest rate in the United States: 8.0% per annum.

❑ Three-month interest rate in Germany: 5.0% per annum.

❑ Current spot exchange rate: €0.800/$.

❑ Three-month forward exchange rate: €0.7994/$.

IRP and Exchange Rate
Determination
Being an arbitrage equilibrium condition involving the (spot) exchange rate, IRP has an immediate
implication for exchange rate determination.

(6.6)

Equation 6.6 indicates that given the forward exchange rate, the spot exchange rate depends on
relative interest rates. All else equal, an increase in the U.S. interest rate will lead to a higher
foreign exchange value of the dollar

(6.7) where
✓ St+1 is the future spot rate when the forward
contract matures,
(6.8) ✓ It denotes the set of information currently
available.
Reasons for Deviations from
Interest Rate Parity
Transactions Costs
◦ The interest rate available to an arbitrageur for borrowing, ib,may exceed the rate he can
lend at, il.
◦ There may be bid-ask spreads to overcome, Fb/Sa < F/S
◦ Thus

(Fb/Sa)(1 + i£b) − (1 + i$ a)  0 (6.11)

Capital Controls
◦ Governments sometimes restrict import and export of money through taxes or outright
bans.
2. Purchasing Power
Parity
IBF301 – CHAPTER 6
Purchasing Power Parity (PPP)
Theory of purchasing power parity (PPP): The exchange rate between two currencies should
equal the ratio of the countries’ price levels:
P$
S($/£) = (6.13)
P£

For example, if an ounce of gold costs $225 in the U.S. and £150 in the U.K., then the
price of one pound in terms of dollars should be:

P$ $225
S($/£) = P£ = £150 = $1.50/£
Purchasing Power Parity and
Exchange Rate Determination
The PPP relationship of Equation 6.12 is called the absolute version of PPP. When the PPP
relationship is presented in the “rate of change” form, we obtain the relative version:

(6.14)

where e is the rate of change in the exchange rate and π$ and π£ are the inflation rates in the United
States and U.K., respectively.
PPP Deviations and the Real
Exchange Rate
If there are deviations from PPP, changes in nominal exchange rates cause changes in the real
exchange rates, affecting the international competitive positions of countries. This, in turn, would
affect countries’ trade balances.

The real exchange rate, q, which measures deviations from PPP, can be defined as follows:

(6.15)
Example:
Suppose the annual inflation rate
is 5 percent in the United States
To summarize, and 3.5 percent in the U.K., and
q = 1: Competitiveness of the domestic country unaltered. the pound appreciated against
q < 1: Competitiveness of the domestic country improves. the dollar by 4.5 percent.
q > 1: Competitiveness of the domestic country deteriorates. What is the real exchange rate?
Evidence on Purchasing
Power Parity

Source: McDonald’s, Thomson

Reuters, The Economist, January
2019.
3. Fisher Effects
IBF301 – CHAPTER 6
The Fisher Effects
The Fisher effect holds that an increase (decrease) in the expected inflation rate in a
country will cause a proportionate increase (decrease) in the interest rate in the
country.
Formally, the Fisher effect can be written for the United States as follows:

(6.16)

Where
$ is the equilibrium expected “real” U.S. interest rate
E($) is the expected rate of U.S. inflation
i$ is the equilibrium expected nominal U.S. interest rate
 International Fisher Effect
If the Fisher effect holds in the U.S.
E($) = (i$ - $ ) / (1 + $ ) ≈ i$ - $
and the Fisher effect holds in U.K,
E( £ ) = (i £ -  £ ) / (1 +  £ ) ≈ i £ -  £
and if the real rates are the same in each country
$ =  £
then we get the International Fisher Effect (IFE): suggests that the nominal interest rate differential
reflects the expected change in exchange rate.
E(e) ≈ i$ - i£ (6.17)
International Fisher Effect
Lastly, when the international Fisher effect is combined with IRP, that is,

(F – S)/S = i$ - i£ /(1 + i£ )

We obtain

(F – S)/S = E(e) (6.18)

which is referred to as forward expectations parity (FEP). FEP states that any forward premium or
discount is equal to the expected change in the exchange rate.

When investors are risk-neutral, forward parity will hold as long as the foreign exchange market is
informationally efficient.
Exact Equilibrium Exchange Rate
Relationships
Exhibit 6.9 – International Parity
relationship among Exchange
Rates, Interest Rates, and
Inflation Rates
4. Forecasting
Exchange Rates
IBF301 – CHAPTER 6
Forecasting Exchange Rates
1. Efficient Markets Approach

2. Fundamental Approach

3. Technical Approach

4. Performance of the Forecasters

4.1 Efficient Markets Approach
Financial Markets are efficient if prices reflect all available and relevant information.
If this is so, exchange rates will only change when new information arrives, thus:
St = E[St+1]
In a sense, the random walk hypothesis suggests that today’s exchange rate is the best
predictor of tomorrow’s exchange rate.
and
Ft = E[St+1| It]
Predicting exchange rates using the efficient markets approach is affordable and is hard to
beat.
4.2 Fundamental Approach
Involves econometrics to develop models that use a variety of explanatory variables.

s = α + β1(m − m*) + β2(v − v*) + β3( y* − y) + u (6.19)

where:
s = natural logarithm of the spot exchange rate.
m − m* = natural logarithm of domestic/foreign money supply.
v − v* = natural logarithm of domestic/foreign velocity of money.
y* − y = natural logarithm of foreign/domestic output.
u = random error term, with mean zero.
α, β’s = model parameters.
4.2 Fundamental Approach
Generating forecasts using the fundamental approach would involve three steps:

❑ Step 1: Estimation of the structural model like Equation 6.18 to determine the numerical
values for the parameters such as α and β’s.

❑ Step 2: Estimation of future values of the independent variables like (m − m*), (v − v*), and
(y* − y).

❑ Step 3: Substituting the estimated values of the independent variables into the estimated
structural model to generate the exchange rate forecasts.

The downside is that fundamental models do not work any better than the forward rate
model or the random walk model.
4.3 Technical Approach
Technical analysis first analyzes the past behavior of exchange rates for the purpose of
identifying “patterns” and then projects them into the future to generate forecasts..

Clearly it is based upon the premise that history repeats itself.

Thus it is at odds with the EMH

4.4 Performance of the Forecasters
Forecasting is difficult, especially with regard to the future.

As a whole, forecasters cannot do a better job of forecasting future exchange rates than the
forward rate.

The founder of Forbes Magazine once said:

“You can make more money selling financial advice than following it.”
Practice
IBF301 – CHAPTER 6
Summary
IBF301 – CHAPTER 6
Summary
1. Interest rate parity (IRP) holds that the forward premium or discount should be equal to the
interest rate differential between two countries. IRP represents an arbitrage equilibrium condition
that should hold in the absence of barriers to international capital flows.

2. If IRP is violated, one can lock in guaranteed profit by borrowing in one currency and lending in
another, with exchange risk hedged via forward contract. As a result of this covered interest
arbitrage, IRP will be restored.

3. IRP implies that in the short run, the exchange rate depends on (a) the relative interest rates
between two countries, and (b) the expected future exchange rate. Other things being equal, a
higher (lower) domestic interest rate will lead to appreciation (depreciation) of the domestic
currency. People’s expectations concerning future exchange rates are self-fulfilling.
Summary
4. Purchasing power parity (PPP) states that the exchange rate between two countries’ currencies
should be equal to the ratio of their price levels. PPP is a manifestation of the law of one price applied
internationally to a standard commodity basket. The relative version of PPP states that the rate of
change in the exchange rate should be equal to the inflation rate differential between countries. The
existing empirical evidence, however, is generally negative on PPP. This implies that substantial barriers
to international commodity arbitrage exist.
5. There are three distinct approaches to exchange rate forecasting: (a) the efficient market approach,
(b) the fundamental approach, and (c) the technical approach. The efficient market approach uses such
market-determined prices as the current exchange rate or the forward exchange rate to forecast the
future exchange rate. The fundamental approach uses various formal models of exchange rate
determination for forecasting purposes. The technical approach, on the other hand, identifies patterns
from the past history of the exchange rate and projects it into the future. The existing empirical
evidence indicates that neither the fundamental nor the technical approach outperforms the efficient
market approach.
PRACTICE
Ex1:
Suppose that the treasurer of IBM has an extra cash reserve of $100,000,000 to invest for six months. The six-
month interest rate is 8 percent per annum in the United States and 7 percent per annum in Germany. Currently, the
spot exchange rate is €1.01 per dollar and the six-month forward exchange rate is €0.99 per dollar. The treasurer of
IBM does not wish to bear any exchange risk. Where should he/she invest to maximize the return?
Ex2:
While you were visiting London, you purchased a Jaguar for £35,000, payable in three months. You have enough
cash at your bank in New York City, which pays 0.35% interest per month, compounding monthly, to pay for the car.
Currently, the spot exchange rate is $1.45/£ and the three-month forward exchange rate is $1.40/£. In London, the
money market interest rate is 2.0% for a three-month investment. There are two alternative ways of paying for your
Jaguar.
(a) Keep the funds at your bank in the U.S. and buy £35,000 forward.
(b) Buy a certain pound amount spot today and invest the amount in the U.K. for three months so that the maturity
value becomes equal to £35,000.
Thank you for your attention!

END OF CHAPTER